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Default fears hit commercial property

Created:
8 May 2008
Written by:
Algy Hall

The Bank of England's recent Financial Stability Report (FSR) has highlighted another potential blight for the UK's reeling commercial property market: debt defaults. It's not hard to see why the Bank is so worried about debt levels. Commercial property lending now accounts for 38 per cent of the stock of major UK bank lending to private non-financial UK corporations, compared with 19 per cent in 1998. In addition, over that period there has also been a fourfold increase in the value of off-balance-sheet commitments to commercial real estate companies. And Capital Economics points out that current loans to the commercial property sector of £202bn equate to 11.6 per cent of all outstanding debt, well above the peak of 10 per cent when markets turned in the early 1990s.

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These precarious debt levels would not be such a worry were it not for recent property price falls. Commercial property prices, as measured by the IPD All Property index, have plunged 16 per cent since their summer peak. What's more, the FSR points out that derivative contracts are currently implying a peak-to-trough fall of 20 to 25 per cent - in other words, the market reckons there's more pain to come. The price falls to date have already threatened the loan-to-value (LTV) covenants attached to some loans, with several listed-property funds having come close to breaches.

Fears are now also mounting about the ability of property investors to service interest payments on loans due to worsening rental conditions, especially in the City office and retail warehouse sectors. The phrase "double dip" has been coined to refer to a possible second leg of the commercial property downturn caused by falling rents which, if severe, could make defaults an increasingly frequent occurrence. The situation is made worse by tight lending conditions which make refinancing existing loans more difficult and costly. The FSR considered a scenario where default rates surge to 10 per cent, against the current benign level of 1.5 per cent, wiping £5.1bn off bank balance sheets.

The possibility that defaults could prompt fire sales by financially-distressed property investors, and banks could take a tougher stance when faced with writedowns, is a grim prospect for an already battered sector. However, should this happen there could be a silver lining in the shape of cash-rich overseas and vulture-fund investors who are thought to be eyeing the UK.

IC VIEW

FairlyPriced

The market is nervous about the highly-geared funds run by asset manager Capital & Regional and, at 348p, its shares are fairly priced. At 848p, British Land's discount to net asset value – 37 per cent to first quarter forecasts – makes it good value despite being the most geared blue-chip Reit, as well as being heavily exposed to City offices and retail warehouses.

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